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Early Retirement and Opportunity Cost

posted on April 5, 2016

Opportunity cost is a fundamental concept in economics. It’s the value of the best alternative forgone. When you choose to do X, you forego the value of doing Y.

Opportunity cost is everywhere in our financial decisions. The opportunity cost for choosing to live in a low-cost-of-living area is the higher pay and more abundant jobs in a high-cost-of-living area. The opportunity cost for contributing to a Roth 401k is the tax deduction you would get from contributing to a traditional 401k.

Life is full of choices. Wherever there are choices, you will have opportunity cost.

Is an opportunity cost just as real as an actual cost out of pocket? Should we discount the opportunity cost by chalking it up to “could’ve had a V8”?

The opportunity cost has to be realistically expected beforehand. It can’t be just a lucky outcome after the fact. The opportunity cost for investing in index funds isn’t buying an IPO that happened to take off.

However, the opportunity cost is every bit as real. If you own your home free-and-clear, your housing cost isn’t just your property tax and maintenance. If you rented, you would free up the money and earn income on it. That’s why “owner’s equivalent rent” is part of the CPI. If you stay at home to take care of your kids, your childcare cost isn’t zero. You are just paying it with the foregone salary from working elsewhere. When you assess your cost of living, you have to include your opportunity cost. Otherwise it isn’t the true picture.

A co-worker takes pride in being frugal and saving money. He brown-bags for lunch every day. He stays at Motel 6 when he travels. When we talked about early retirement the other day, because he’s interested in some leisure activities, I said the largest cost of early retirement isn’t housing or health care. It’s the opportunity cost — the income he’ll give up if he retires early.

At his after-tax income, it’s like buying a few new BMWs each year and sending them to the junk yard without even bothering to trade them in, just so he can spend his time the way he likes. When he asked me what was the point in penny-pinching and turning around throwing away money like that, I didn’t have a good answer, except by saying that early retirement is a luxury lifestyle.

When your time is valued highly by others for doing things you do well, you will have to pay the same high price (after taxes) if you want to spend your time on something else. There’s nothing wrong in pursuing a luxury lifestyle. Luxuries are usually more enjoyable. It’s just the polar opposite of being frugal.

I’m not saying retiring early isn’t worth a few BMWs each year. The cost and its luxury nature just have to be recognized. People with a higher income tend to have this choice. The higher opportunity cost makes the choice more difficult. People who are more frugal tend to have this choice. The contrast between the frugal habits and the high opportunity cost also makes the choice more difficult. Ironic, isn’t it?

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Comments

Thought-provoking as usual, Harry. I consider ‘cost’ in virtually everything I do. Whether it’s letting someone into traffic (is the overall traffic flow better served by me letting them in and freeing up the 10 cars queued behind them, or by me leaving them there so the cars behind me aren’t unduly held up (I know – it’s a curse ; )), to determining whether it’s better to buy the large pizza v the medium (using pi*r-squared, and calculating the spoilage % if I don’t eat or save the large pizza’s leftovers). It’s kind of a fun game to me as opposed to a chore, and given I’m nearly financially independent, it’s not really necessary any longer but I’ll likely do it as long as I’m alive.

That said, there’s a cost to working for money as opposed to living without the majority of responsibilities we all have. To me, it’s a form of Maslow’s hierarchy where, if you’re lucky, you move from the thinking of ‘if I work 2 more years, I can save X more $ and be that much more affluent’ to ‘I have enough, and I’m not willing to trade my literal life just to accrue more $’. One is finite (life), and the other you could spend the rest of your life acquiring and yet be left wanting no matter how successful your pursuit. I didn’t have this perspective 10 years ago when I was so much farther from my wealth goals, so it was admittedly a bit of a surprise to me when my perspective changed. I thought I’d work until I was 70 and now I don’t want to work past 60 so I can enjoy my remaining years with good health for as long as possible.

Per all of the research, most aren’t fortunate enough to have the luxury of making the “life v more wealth” decision since they are too busy just trying to save enough to even retire at all. And far be it from me to judge anyone for how they choose. It’s just that, as an unrepentant CBA cost-calculator for my entire adult life, in 3-4 years (without any major market disasters) life is going to win out over more $ .

I sometimes say to people, when they are thinking about retiring early, that continuing to work is “selling the best remaining years of your life for money.” Somewhere around 55, people seem to comprehend this reality. On the other hand, part time work can be as enjoyable as many other retirement pursuits. I continue to work part-time, but only on things I enjoy doing, with people I enjoy working with. It’s pretty much like grad school, but far fewer hours (average of 5.5 h/wk in 2015, with a max of 21h) at a much higher pay rate. Having wages also lets me “tune” my taxable income, using 401(k) and traditional IRA contributions, so that I can leverage tax credits and health insurance cost-sharing to minimize the cost of health insurance, and reduce taxes. I consider myself very lucky to be working “as a hobby.”

I think in some ways you have it right, except that you calculate the free time and potential health benefits at a very low $ rate relative to a BMW or a few BMW’s in your example. It’s not the same as buying a few BMW’s if you value your health and free time and pursuit of interests and hobbies outside of work as much higher than the value of more material things and trips and such.

Most people do NOT evaluate opportunity cost, even and maybe most especially in business. Perhaps because it takes some thought.

Opportunity costs are everywhere in life. But I don’t believe lost earnings are enough to override retiring early (if you can afford it and want to). If you consider lost wages as a opportunity cost you might as well work forever. On the other hand, if you value leisure time and engaging in your favorite hobbies and activities more valuable than more money then The article compares not working to buying 2 new BMW ‘s a year. This may be true mathematically but what if you value free time to pursue your interests more than the’ BMW’s?

I added a new paragraph at the end to make it clear I’m not saying that retiring early isn’t worth it. My co-worker has a difficult decision because of the high opportunity cost of his time and his frugal habits. It would be much easier if he earns less or if he isn’t as frugal.

“I added a new paragraph at the end to make it clear I’m not saying that retiring early isn’t worth it. My co-worker has a difficult decision because of the high opportunity cost of his time and his frugal habits. It would be much easier if he earns less or if he isn’t as frugal.”

And that is the irony of the situation. If they earned less or wasn’t as frugal perhaps they wouldn’t be able to retire early. I like to make my decision on what John Bogle said – to know when you have “enough”. When you have enough financial assets to retire does it really make sense to accumulate more? If you accumulate 2 or three times “enough” will it enhance your life? For some it does if they want to leave a large estate. For others it makes no sense at all. Do you like your work? Do you have activities you want to persue? Do you see relatives or friends your age coming down with serious illnesses or leaving this earth early? It is a personal decision, what’s right for one is wrong for another.

Beyond opportunity cost and the predicament facing your colleague, there is a value judgement of difference if any the marginal earnings make to his wealth, health, life etc. If you have enough wealth, throwing away a few BMWs to junkyard may not mean much. Essentially, we are talking about marginal utility of wealth. Your colleague should not discount the value of accumulated wealth. May be in relation to that accumulated wealth, additional earnings are not going to make any difference.

For the lifelong frugal who is on the cusp of having saved enough to retire, there’s a sort of guilt/fear associated with the switch from accumulation to distribution that is stronger than for those who are less frugal. Continuing to work part-time provides not only a means of delaying distribution, but a means of gradually weaning oneself off the teat of positive cash-flow. As the size of the wage income declines, it becomes easier to make the break. This presupposes that someone will be willing to hire you for the number of hours that you are willing to work, but I’ve found that it IS possible. The halls of our facility are full of early-retirees who get rehired as contractors, to the extent that upper management has stopped giving packages to induce early retirement. Most of those who return feel they must work, but the point is that they DO get hired, and, in my case at least, ARE allowed to work much less than full-time. I would suggest that actively pursuing a part-time transition would be part of a well-conceived, early-retirement plan. I’d venture to say that this happens ad hoc in most cases, but that isn’t to say that it couldn’t be planned. We need to plan for living 30-50 years after retirement (if we are so lucky), so why not plan in a 3-10 year transition, rather than leaving it to chance?

I agree that would be ideal. Many will be very happy with half the pay for half the work. However in my industry and area, ageism is already a problem. Younger employees are more productive and less expensive. The nature of the work also doesn’t lead well to part-time work because someone else can’t easily pick up where you leave off. Two people working half time each can’t do what one person does. If you are not riding along with the rest of the team you can’t be effective because you don’t know what’s the latest.

In order to find part-time work, chances are you’d have to do something different, which requires different skills and likely carries a much lower pay rate. When one year of full-time work in the current job beats five years of part-time work in a different job, doing the current job until you don’t need the money any more becomes more effective.

Well, as Branch Rickey (innovative GM of the Cardinals, Dodgers, and Pirates) is supposed to have said: “Luck is the residue of design.” I can’t claim to have designed my current situation, except that planning very early for early retirement (as I think is even more your case) did enable me to jump at the chance when inducements were offered. The aftermath, in which I was hired back, was unplanned. However, once you are back in the trenches, it’s not too hard to identify things that need done that you are well-suited to do–presuming you had skills in the first place. Having a few well-placed friends and acquaintances who respect your skills helps a lot, too. Making those connections during your full-time career is critical to creating the transitional part-time career.
As for changing job roles, I was a project manager, which obviously takes more on-site time, but many of us also have a past in which we were technical experts and individual contributors–that’s why we were “promoted” to managing. Migrating back to the individual contributor, technical role has reduced the need for me to be on-site, and is actually the work I enjoy the most. And even though my pay rate may seem expensive at first glance, I’m still far cheaper than the rate for a fully-burdened onsite employee who couldn’t do what I do technically. This past month, they finally took me up on my offer to do without a desk and a phone (that I never used). So, by reducing my overhead costs, it becomes painless for them to keep me on the rolls. I can work when there’s work to do, and cruise along without causing any bleeding when there isn’t. Anyway, what I’m suggesting is that there are ways we can influence the probability that we will be able to maintain a part-time job at a reasonable pay rate.

Thank you. That’s a great topic for a follow-up: what types of jobs are set up well for part-time and still pay a good rate. There are also different types of part-time, 2 days a week versus 5 months in a year but full-time during those 5 months.

I buy a bottle of Scotch for $100 and ten years later that same bottle has become a collectors item selling at auction for $10,000. If I decide to open that bottle and drink it, am I drinking a $100 bottle of whisky or a $10,000 bottle of whisky?

I’ve struggled with this article. I see your point about trade-offs, but I’m not sure of the motive besides creating a thought experiment. Regardless of your intention, I’d offer a suggestion: replace BMWs with something else. How about purchasing and throwing away 50,000 Big Macs each year. Or 10,000 packages of jumbo roll toilet paper. It’s the same tradeoff concept, but instead of “wasting luxury” you’re avoiding purchasing an absurd amount of stuff you could never hope to use. To most people, several new BMWs is an absurd amount of cars they could never use–not a “cost” of retiring early.

I think KD nailed it when bringing in the concept of marginal utility of wealth. I think this has to be part of the thought experiment.

The motive: to highlight the difficult decision facing those who are in a position to retire early, especially those who reached such position through high income and low spending. Pulling the plug means a drastic switch from low spending to high spending (buying time).

If you don’t care about BMWs (I don’t either), there are always other luxuries. A trip to Antarctica? Golf coach? First class seats instead of Economy? If you don’t care about spending the money on yourself, are there causes you care about? Inner-city youth? Children in Africa?

High spending = buying time, is a great description of the dilemma. But it is also very disempowering. I would say, you always own your time, and now you refuse to sell it for income since you have accumulated enough wealth aka your marginal utility of wealth has diminished to an extent where selling time for income is not worth it to you.

Perhaps the driver for the more-intense-than-usual discussion is that, while we can all understand judging the work vs. retirement trade-off as idealized “rational actors,” the non-zero uncertainty about the outcome makes the decision about retiring early a fraught one. Those who are experiencing that uncertainty probably have more trouble looking at it as a dispassionate, binary decision. As one who is in the 7th year of an unplanned transition between the states of fulltime employment and retirement, I can recommend planning in a part-time transition phase. It’s psychologically difficult to give up positive cash-flow cold turkey, but over time, as my hours have declined (by choice), selling my time for money has become more an issue of interest than of income. When it’s no longer interesting, it will be much easier to cut the cord than it would have been 5 years ago. To pick up on KD’s point, the utility of the additional income will have declined below breakeven. However, it’s not simply a case of a calculation of utility having reached a long-ago determined solution. Over time, the experience at a reduced (part-time) income, as well as the additional aging, has affected my perception of the utility of income, and so the path has affected the solution (let’s say it’s at least a partial differential equation!).

KD – I guess cato in the comments above is also eluding to this. You own the bottle of Scotch. You want to drink it. Except others now set a $10,000 price tag on it. What do you do? Is it a $10,000 bottle? Absolutely. It’s easier with Scotch. If you don’t perceive as much difference, you just sell it for $10,000, buy another $500 bottle and still have $9,500 to spare. A $500 bottle is still very enjoyable.

Exactly when the marginal utility diminishes would also be a great follow-up topic. If you can double your wealth in one year you likely will stay on. Add another 1%, likely not. What about 20%? 10%? 5%? Harder to say.

My take on this subject, which I have thought about long before getting gray hair: No amount of money can buy back time. My checkered career has included 5 sabbaticals (not academic, just seems the best term) totaling 8 years. I can absolutely calculate the cost to that in the case of SS, by assuming my income continued. I have never doubted the wisdom of choosing this path, regardless. I also think age has a tendency to erode enthusiasm for doing many things one plans for in retirement. I see this in myself, and others. Best to do them when you’re young. Granted, staying single made this possible for me, probably not for most. It is indeed all about tradeoffs, and undeniably personal. I grasped the concept of “enough” soon enough; that is the best benefit to being frugal, not the money saved.

Apologies if I’ve missed the point but if the opportunity cost of earning a high rate per hour doing ‘unpleasant things’ (i.e. work) is earning a low rate per hour to do ‘lovely things’ (i.e. spend my time as I please) then that seems a fair trade to me.

It’s also not at odds with my current propensity to frugality. I currently sell every hour as dearly as possible and therefore spend little precisely so I don’t have to do so in the future. The difference is control / independence.

My working assumption is that whatever terms I get now may well be worse in the future – e.g. working conditions / pay rates decline, I age and am less willing / able to earn / put up with it all.

Therefore my current frugality is driven by the very desire to earn less or spend more in the future rather than because it’s intrinsic to my nature.

Fundamentally that’s driven by my disbelief in a constant happy medium in the future e.g. a three day week that showers me with loads of cash.

The higher rate I earn at the moment is largely dedicated to buying the future time I have remaining (once essential expenses have been taken into account, then buying my time is the most valuable thing I can think of).

Once I’ve bought all the future time I can reasonably expect (it’s limited after all) then my marginal utility of wealth drops off a cliff. Which makes the opportunity cost of switching from high income to low income and from low time to high time feel like a trade I can’t make soon enough.

No doubt doing lovely things is desirable but the opportunity cost is still there and it has to be recognized. It’s a luxury to be able to say no to a high earning rate others would only dream of and would go much greater length to get it.

On the way to the point you are in a position to say no, you likely sacrificed time and comfort in order to save money, such as my co-worker’s brown-bagging for lunch and staying at basic motels. If you spent extra 15 minutes on brown-bagging in order to save $3 only yesterday, and you face the decision to refuse $1,000 for coming in tomorrow, and another $1,000 the day after, it’s a tough shift, at least for my co-worker. It makes his brown-bagging exercise look pointless.

I think the point you raise in this article is valid, but I don’t think you can limit it to only early retirement. The opportunity cost argument applies to RETIREMENT–full stop. Whether you retire at 40, 50, 60, 70, or later, when you’ve retired from a high income job, you’re dealing with the opportunity cost.

Once you remove the “early” restriction, the argument falls apart for me. Essentially it says: “Spend all the money you make, sacrifice nothing to maximize comfort, and work until you die.”

If you have a high income, it doesn’t matter whether you retire at 40 or work until you die at age 90 and spend all you make. You’re living a luxurious lifestyle either way. The early retiree “sacrificed” comfort to save a lot of money and now has the luxury of free time. The person who worked until death “sacrificed” free time but had the luxury of comfort.

Luxury isn’t the polar opposite of frugal. Being frugal with money allows the luxury of spending on free time. Being frugal with free time (which essentially what the never-retire person is) allows the luxury of spending money on comfort.

T-Rav – I don’t understand how you read the “argument” as “Spend all the money you make, sacrifice nothing to maximize comfort, and work until you die.” while agreeing there is an opportunity cost. Precisely because someone has been sacrificing all along, that person finds it difficult to all of sudden “spend” the large opportunity cost on him- or herself.

It’s true the opportunity cost exists at any age. It’s amplified at the “early” age when it looks large relative to the accumulated pile so far. If you are able to add 30% to your pile by working one extra year, while you are still relatively young, it’s tempting to permanently elevate your available spending for the rest of your life by 30% and expand your options. If that number is 0.3% and you are already 75, not so much.

I think I’m dense and not getting the point you are trying to make. I just don’t see it as not spending money on yourself for years and then spending a bunch on early retirement. If you make $150k, live frugally, and save $100k of it, aren’t you still spending $100k on the savings? You’re pre-purchasing the future time that an additional $100k in savings will provide.

It’s similar to saving up for months to make a big purchase in cash. And it’s the complete opposite of buying on credit and paying later.

Maybe it’s the perspective of the accumulation? Instead of approaching it from the point of saving XX more to increase options, one can come at it from the point of needing XX to reasonably secure a specific set of options. Every dollar saved is spending on that goal, therefore: high frugality = high savings = high spending today.

Thanks for the replies. I’m not trying to obnoxious. After years of nodding in agreement with your articles as I read them, I find this one to be different. For my sanity, please don’t ask me to calculate the opportunity cost of the time I’ve spent thinking about it! 🙂

T-Rav – You equate saving with pre-committed spending, therefore “high frugality = high savings = high spending today.” Not all see it that way. You may have heard of a frugal janitor leaving millions after living a modest life. Not that everyone should live that way, it just shows some (many? most?) people have a clear separation between saving and spending.

The point of brown-bagging is so you don’t have to come in tomorrow. It’s not surprising that someone on the brink of achieving the goal feels some doubt. It’s an unusual path to follow, role models are scarce, social pressure is strong, it feels like you’re taking a risk by giving up an obvious source of security. We can rationalise it but the emotional disquiet of taking a leap into the unknown is likely to be significant.

For the quantitative among us, the original post (on April 5th) was 528 words long. During the ensuing month, there have been 31 replies (not including this one), 9 from Harry, and 22 from 12 other contributors, totaling about 2900 words. This seems to be an indication of stronger than usual interest, mostly borne of differing perspectives on how we feel about working vs. doing other things that matter to us, and about buying things now vs. saving for retirement (so that we can buy things later, when we aren’t working). As many have said, these choices involve evaluating the tradeoffs. Harry’s original post framed the tradeoffs within the economic concept of opportunity cost, which, from the responses, isn’t how most of us have considered them. That’s why we read Harry. Anything that pushes us to consider things we haven’t, or to reconsider things we thought we already knew, is valuable. Thank you, Harry! Please add this to your list of things to incorporate into your book–The Thinking Person’s Guide to Preparing for Retirement.

I am late to the party again, but this point is one I often make when people consider stopping work and taking social security at age 62. The biggest difference between (stop/start) at 62 and (stop/start) at 66 is four years of income, not the larger social security benefit.

Or is it? At least in this case, they are both on the same side. Delaying increases both current income and future income.

The same is true if you will receive a pension based on years of service. The value of working a few more years comes more from the income than from the increased pension benefits.

“The article isn’t saying don’t retire early. It is pointing out a cognitive dissonance issue. Frugal people like to think they don’t “waste” money on luxury goods. But retiring early is one of the most expensive luxury goods out there as we are talking millions of dollars (do the math on something like 40k/yr of savings for 10 years and then compound it over another 20 to compare the 50 to 60 year old retiree estate isze) So how do you reconcile the self image of being a frugal person with buying this expensive luxury good? The answer is to recognize that luxury goods are worth it. You just need to pick the ones that make you happy (BMW vs not having to go to work). And obviously this isn’t an either or thing.”

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